Resources at lowest valuations in over a decade

Andrew Dittberner, Senior Investment Manager at Cannon Asset Managers, argues that resources are at their lowest valuations in over a decade and value investors should start nibbling. As always, stock selection and price paid will be the key to success.

The weighting of resources shares in the ALSI has fallen from 47.3% to 31.7% over the last 5 years. This spectacular fall from grace has largely gone unnoticed by investors who have fallen out of love with the sector, and this could present a really interesting investment opportunity. The resource index’s PE ratio has fallen from 16.5 times to 9.5 times over the past year, despite the fact that it has been the best performing sector in terms of real earnings growth. Specifically, over the five years to August 2012, resources earnings have grown by 112% ahead of inflation, as can be seen in Figure 1 below.

Earnings in the industrial sector have lagged, with growth restricted to an inflation-adjusted 98% over the five years, while financials brought up the rear with a rise in earnings of only 60% in real terms over the same period.

Over the same time frame, the indices have behaved contrary to the underlying earnings performance, resulting in a substantial rerating of the industrial and financial indices and a derating of resources. Figure 2 below shows that the industrial index has doubled over the past five years whereas the resources index has remained flat. Even the financial index, with the weakest overall growth in earnings, managed to pull off a 37% rise since August 2007.

In addition, looking at the Cyclically-Adjusted PE (CAPE) ratios for the different super-sectors, we see that, for the resources sector, the CAPE ratio has slipped from 28 times in August 2007 to the current level of 11 times, its lowest level since the late 1990s. The CAPE ratio looks at the through-the-cycle (seven-year) PE ratio, resulting in a metric which gives a more accurate representation of value as it caters for the volatility of company earnings in the near-term.

An interesting by-product of this performance is the fact that resources now account for a mere 31.8% of the JSE All Share Index. For a country of which the primary export is commodities, this is remarkable and could be a reflection of global investor wariness of the South African mining industry. The proportion of the index comprising resources has slipped from nearly a half (47.3%) in August 2007 to less than a third just five years later.

The big winner has been the industrial sector, which has swelled from a third (32.7%) to nearly a half (47.2%), largely mopping up all of the resources’ losses. The financial sector showed only a modest rise from 20% to 21%.

It has been over a decade since we have seen resources valued at these levels in terms of the CAPE ratio. Although the short-term outlook for resources may be clouded by the current labour unrest, the struggling developed world and concerns around a Chinese slowdown, we believe that there are some opportunities opening up for investors in this sector. However, stock selection and paying the right price, as always, remains a key component of investment success.

Two resource companies that Cannon Asset Managers is currently invested in are African Rainbow Minerals (ARM) and Pan-African Resources (PAN). ARM provides an excellent entry into the resource sector via its investments in a diversified range of resources, which include both base metals as well as some exposure to precious metals. ARM trades on exceptionally compelling multiples as evidenced by its single digit PE ratio of 9.2 times, a forward PE ratio of 7.5 times and a dividend yield of 2.7%. Coupled with this, by our measures, ARM is considered a business of high quality, with a sound balance sheet.

Pan-African Resources is a junior gold mining business with a small exposure to platinum through their recently developed Phoenix tailing plant in the North West province. PAN’s strategy is to focus on high-quality ore bodies, where they are able to extract the gold at relatively low cash costs. Recently, they announced a large transaction which is expected to set the company on the path to mid-tier production status. PAN’s share price currently enjoys very strong momentum with the price increasing by about 70% over the past 12 months. Yet, despite this momentum, the share trades on an attractive PE ratio of 10 times historical earnings and has been a consistent dividend payer over its short history.